Chapter 5 Inventories and Cost of Goods Sold Using Financial Accounting Information: The Alternative to Debits and Credits , 6/e by Gary A. Porter and Curtis L. Norton Copyright © 2009 South-Western, a part of Cengage Learning.

Inventory of Wholesalers and Retailers Purchased in finished form Resold without transformation Classified as “Merchandise Inventory” on balance sheet LO1

Gap, Inc. Consolidated Balance Sheets [Partial] ASSETS (in millions) February 3, Janurary 28, 2007 2006 CURRENT ASSETS: Cash and cash equivalents $ 2,030 $ 2,035 Marketable securities 570 952 Accounts receivable 44 55 Merchandise inventory 1,796 1,696 Other 589 501 TOTAL CURRENT ASSETS 5,029 5,239 More than 1/3 of current assets

Inventory of Manufacturers Costs Included in Inventory Direct materials Direct labor Manufacturing overhead

Inventory of Manufacturers Balance Sheet Classifications Costs Included in Inventory Direct materials Raw materials Manufacture products Direct labor Work in process Manufacturing overhead Finished goods

Caterpillar, Inc. Consolidated Balance Sheets [Partial] ASSETS (in millions) 2006 Current assets: Inventories: Raw materials $ 2,182 Work in progress 977 Finished goods 2,915 Supplies 277 Total inventories $ 6,351

Condensed Income Statement for a Merchandiser Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Selling and administrative expenses 29,300 Net income before tax $ 10,700 Income tax expense 4,280 Net income $ 6,420 LO2

Net Sales and Contra-Sales Accounts Sales revenue The inflow of either cash or accounts receivable from the sale of a product Normal balance Two deductions from sales: sales returns and allowances sales discounts normal debit balance normal debit balance

Sales Returns and Allowances records inventory returned by customers who are not completely satisfied a customer may be given an allowance for spoiled or damaged merchandise single account used to record both returns and allowances Normal balance normal debit balance

Credit Terms and Sales Discounts n/30 Payment due 30 days from invoice 1/10, n/30 Deduct 1% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days 2/10, n/30 Deduct 2% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days

Net Sales Sales revenue $103,500 Less: Sales returns and allowances 2,000 Sales discounts 1,500 Net sales $100,000

The Cost of Goods Sold Model Beginning inventory Purchases of merchandise + = Goods Available for Sale Less: Ending inventory Cost of goods sold = LO3

The Cost of Goods Sold Model Beginning inventory $ 15,000 + Cost of goods purchased 63,000 = Cost of goods available for sale 78,000 – Ending inventory (18,000) = Cost of goods sold $ 60,000 An increase in ending inventory means more was bought than sold “Pool” of goods available to sell during the period

Perpetual Inventory Systems Inventory records are updated after each purchase or sale Point-of-sale terminals have improved the ability of mass merchandisers to maintain perpetual systems

Periodic Inventory Systems Inventory records are updated periodically based on physical inventory counts Reduces record keeping but also decreases the ability to track theft, breakage, etc., and prepare interim financial statements

Cost of Goods Purchased Includes invoice price: Less: Purchase returns and allowances Purchase discounts Plus: Transportation-in

To record purchase of inventory. Recording Purchases Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues -- Expenses Equity Accounts Purchases Payable 4,000 (4,000) To record purchase of inventory.

Recording Purchase Returns and Allowances Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues -- Expenses Equity Accounts Purchase Returns and Payable (850) Allowances 850 To record inventory returned to supplier.

Recording Purchase Discounts Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues -- Expenses Equity Cash (495) Accounts Purchase Payable (500) Discounts 5 ($ 500 × 1% = $5 discount) To record payment within discount period to supplier who offers 1% purchase discount.

Title passes at destination FOB Destination Point Title passes at destination No sale or purchase until inventory reaches its destination Seller responsible for inventory while in transit

Title passes when shipped FOB Shipping Point Both sale and purchase recorded upon shipment Buyer responsible for inventory while in transit Title passes when shipped

Analysis of Profitability particular interest to current and potential investors Gross Profit % LO4 14 14

Gross Profit Ratio = Gross Profit Daisy’s Profitability Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Gross profit ratio = 40% Gross Profit Ratio = Gross Profit Net Sales (How many cents on every $ of sales are left over after covering the cost of the product) 15 15

Inventory Valuation and Income Measurement Value assigned to inventory on balance sheet Value expensed as cost of goods sold on income statement When Sold = LO5

Inventory Costs Included Any freight costs incurred by buyer Cost of insurance for inventory in transit Cost of storing inventory before selling Excise and sales taxes

Inventory Costing Methods Four costing methods available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO) LO6

Detailed Costing Method Example Beginning inventory, Jan. 1: 500 units (unit cost $10) Inventory purchases: Date Units Unit Cost 1/20 300 $ 11 4/8 400 12 9/5 200 13 12/12 100 14 Total purchases 1,000 units Ending inventory, Dec. 31: 600 units Calculate the cost of goods sold and ending inventory under each cost flow method

Specific Identification Method Step 1: Identify the specific units in inventory at the end of the year and their costs.

Units × Cost = Total cost Specific Identification Method Units in ending inventory: Date purchased Units Cost Total Cost 1/20 100 $11 $ 1,100 4/8 300 12 3,600 9/5 200 13 2,600 Ending inventory 600 $ 7,300 Units × Cost = Total cost

Specific Identification Method Step 2: Identify the units sold and calculate the cost of goods sold.

Units × Cost = Total cost Specific Identification Method Date purchased Units Cost Total Cost Beg. inventory 500 $10 $5,000 1/20 200 11 2,200 4/8 100 12 1,200 12/12 100 14 1,400 Cost of goods sold 900 $9,800 Units × Cost = Total cost

Weighted Average Method Step 1: Calculate the cost of goods available for sale.

Weighted Average Method Date purchased Units Cost Total cost Beg. inventory 500 $10 $ 5,000 1/20 300 11 3,300 4/8 400 12 4,800 9/5 200 13 2,600 12/12 100 14 1,400 Cost of goods available for sale 1,500 $17,100

Weighted Average Method Step 2: Divide the cost of goods available for sale by the total units to determine the weighted average cost per unit.

Cost of Goods Available for Sale Units Available for Sale Weighted Average Method Cost of Goods Available for Sale Units Available for Sale $17,100 1,500 = $11.40/unit

Weighted Average Method Step 3: Calculate ending inventory and cost of goods sold by multiplying the weighted average cost per unit by the number of units in ending inventory and the number of units sold. × Avg. Cost # of Units

Weighted Average Method ALLOCATE TO Ending Cost of Inventory Goods Sold Units on hand 600 Units sold 900 Weighted average cost × $11.40 $ 11.40 Total cost of goods available of $17,100 allocated: $6,840 $10,260

First-in, First-out (FIFO) Method Step 1: Assign the cost of the beginning inventory to cost of goods sold.

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 $5,000 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14

First-in, First-out (FIFO) Method Step 2: Continue to work forward until you assign the total number of units sold during the period to cost of goods sold. Allocate the remaining costs to ending inventory.

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 $5,000 1/20 300 $11 3,300 4/8 300 / 100 $12 $3,600 1,200 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS $7,600 $9,500

Last-in, First-out (LIFO) Method Step 1: Assign the cost of the last units purchased to cost of goods sold.

Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14 $1,400

Last-in, First-out (LIFO) Method Step 2: Work backward until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory).

Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 $5,000 1/20 100 / 200 $11 1,100 $ 2,200 4/8 400 $12 4,800 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS $6,100 $11,000

Comparison of Costing Methods Cost of Goods Sold Goods Available for Sale Ending Inventory Specific Identification $7,300 $ 9,800 $17,100 Weighted Average 6,840 10,260 17,100 FIFO 7,600 9,500 17,100 LIFO 6,100 11,000 17,100 LO7

Comparison of Costing Methods Weighted Average FIFO LIFO In periods of rising prices: Highest cost of goods sold? Lowest cost of goods sold? Highest gross profit? Lowest net income? Lowest income taxes? X

LIFO Issues LIFO liquidation Liquidation can result in high gross profit (and large tax bill) LIFO conformity rule If used for tax, LIFO must also be used for books LIFO reserve Difference between inventory value stated at FIFO and value stated at LIFO

Reasons for Inventory Errors Mathematical mistakes Physical inventory counting errors Cutoff problems – in-transit Goods on consignment LO8

Effect of Inventory Errors on the Income Statement, 2008 Reported Corrected Effect Sales $1,000,000 $1,000,000 Beginning inventory $ 200,000 $ 200,000 Add: Purchases 700,000 700,000 Goods available for sale $ 900,000 $ 900,000 Less: Ending inventory 300,000 250,000 $50 OS Cost of goods sold $ 600,000 $ 650,000 50 US Gross margin $ 400,000 $ 350,000 50 OS Operating expenses 100,000 100,000 Net income $ 300,000 $ 250,000 50 OS OS = overstatement US = understatement

Effect of Inventory Errors on the Income Statement, 2009 Reported Corrected Effect Sales $1,500,000 $1,500,000 Beginning inventory $ 300,000 $ 250,000 $50 OS Add: Purchases 1,100,000 1,100,000 Goods available for sale $1,400,000 $1,350,000 50 OS Less: Ending inventory 350,000 350,000 Cost of goods sold $1,050,000 $1,000,000 50 OS Gross margin $ 450,000 $ 500,000 50 US Operating expenses 120,000 120,000 Net income $ 330,000 $ 380,000 50 US OS = overstatement US = understatement

Counterbalancing Errors Assume ending inventory is overstated (+) by $50,000 in 2008: 2008 Beginning inventory xxx,xxx Add: Purchases xxx,xxx = Goods available for sale xxx,xxx Less: Ending inventory +50,000 = Cost of goods sold –50,000

Counterbalancing Errors 2008 ending inventory becomes 2009 beginning inventory: 2008 2009 Beginning inventory $xxx,xxx +50,000 Add: Purchases xxx,xxx = Goods available for sale xxx,xxx Less: Ending inventory +50,000 = Cost of goods sold –50,000

Counterbalancing Errors The 2008 error reverses in 2009 (but 2008 inventory both 2008 and 2009 profits are misstated by 50,000): 2008 2009 Beginning inventory $xxx,xxx $+50,000 Add: Purchases xxx,xxx xxx,xxx = Goods available for sale xxx,xxx +50,000 Less: Ending inventory +50,000 xxx,xxx = Cost of goods sold –50,000 +50,000

Report loss in year market falls below cost… Lower of Cost or Market Before After Price Price Change Change Cost $100 $80 Report loss in year market falls below cost… LO9

normal gross profit % when sold Lower of Cost or Market Before After Price Price Change Change Selling price $100 $ 80 Cost 75 60 Gross profit $ 25 $ 20 …to maintain normal gross profit % when sold Gross profit % 25% 25%

Lower of Cost or Market Market = replacement cost (not retail value) Cost determined under one of the costing methods Justified on basis of conservatism Can be applied to: Entire inventory Individual items Groups of items

Estimating Inventory Value Sometimes impossible or impractical to measure inventory at cost Estimation is necessary Two methods used to estimate ending inventory values: Gross profit method Retail inventory method LO10

Use income statement model but Gross Profit Method Beginning Inventory + Purchases = Cost of Goods Available for Sale – Ending Inventory = Cost of Goods Sold Use income statement model but reverse last two steps

*Cost of goods sold is estimated as a percentage of sales Gross Profit Method Beginning inventory $1,200 + Purchases 3,500 = Cost of goods available for sale 4,700 – Cost of goods sold (estimated)* 4,200 = Ending inventory (estimated) $ 500 *Cost of goods sold is estimated as a percentage of sales

Inventory Turnover Ratio Cost of Goods Sold Average Inventory The number of times per period inventory is turned over (i.e., sold) LO11

Number of Days’ Sales in Inventory Number of Days in the Period Inventory Turnover Ratio The average number of days inventory is on hand before it’s sold

Statement of Cash Flows Cash Flows from Operating Activities: Net income xxx Increase in inventory – Decrease in inventory + Increase in accounts payable + Decrease in accounts payable – - OR - Cash paid for inventory purchases – Indirect Method Direct Method LO12

Inventory Costing Methods with the Use of a Perpetual Inventory System Appendix Accounting Tools: Inventory Costing Methods with the Use of a Perpetual Inventory System

FIFO Costing with a Perpetual System FIFO applied at time of sale Same FIFO inventory total under periodic and perpetual systems

LIFO Costing with a Perpetual System LIFO applied at time of sale Different LIFO inventory total under periodic and perpetual systems because of pricing gap

Moving Average with a Perpetual System New weighted average cost is computed for each purchase Different inventory total under weighted average (periodic) and moving average (perpetual)

End of Chapter 5